Market Musings 080225: Challenging the conventional wisdom around American exceptionalism

Market Musings 080225:
Challenging the conventional wisdom around American exceptionalism

Is the US really so exceptional and can this exceptionalism really continue for the long term? Certain things are quite clear and cannot be disputed.

First of all, in terms of US economic growth, we have seen outperformance versus the rest of the world with superior productivity growth in particular so we can't argue with the fact that the US economy has grown strongly over the last few years.

US GDP growth has been strong

Secondly, at least in dollar terms, it is still the largest economy in the world with unchallenged reserve currency status for the US dollar. There's no doubt that the US dollar is the date facto global currency accepted pretty much everywhere.

Thirdly, when we look at the stock market, it's quite clear that the US stock market, led by the S&P 500 index, has outperformed for 10 plus years on the back of particularly strength in the technology sector on the back of strong earnings growth from this sector. So over the past decade, US equities have delivered an impressive 14.8% annualized return per year, outpacing global ex-US equities, which delivered only 7% and euro area equities delivering 7.8% per year. So clearly, massive, consistent outperformance from US equities over the long term.

S&P 500 has massively outperformed World ex US in $

And that's been compounded by a strong US dollar, which has been more or less the case since 2011. If we look at the DXY US dollar index, in 2011 the level was 73, today the level is 108. So over this period, substantial appreciation of the US dollar against a basket of other currencies, including the euro, the Japanese yen and the British pound.

DXY US Dollar index has trended higher since 2011

The consensus view today is, given all of these facts, why buy any stock market outside the US?

Well, I have some challenges to this consensus view, this consensus narrow, and they are the following.

First of all, I believe that US economic growth is set to slow, as many consumers are showing poor sentiment. If you look at the University of Michigan Consumer Sentiment survey, it's quite clear that two thirds of the household survey, the ones with lower or middle incomes, not the highest incomes, but the lower or middle incomes, are showing very poor consumer sentiment and see a very weak current financial situation. I think that is largely the outcome of the very high inflation rates that we've experienced, post-COVID and post-Ukraine, up until recently.

University of Michigan Consumer Sentiment: Present Situation

Secondly, I believe that it will be difficult to maintain the debt-funded government spending splurge that the Biden administration undertook over the last four years, particularly because of COVID and after COVID. But including, of course, the Inflation Reduction Act and the Chips Act aimed at boosting investment in the US.

Plus, let's not forget that President Donald Trump has said that he would actually prefer a weaker, not a stronger US dollar, in future, in order to support domestic manufacturing amongst other things.

See this BNP Paribas economics article “Could Trump drive down the dollar?“ for more details on this (click link here).

Note that since October 2022, the beginning of the current bill markets, the excellent performance of US large caps is at least half due to the revaluation of the S&P 500, and the Magnificent 7 in particular, which have driven them to lofty valuations. In the case of the S&P, the valuation was 15.5x forward earnings in October 2022. Today's P/E is 22x, a 50% higher valuation, and the Magnificent 7 are now trading at around 30x forward earnings, very high valuations versus any point in previous history.

Magnificent 7 forward P/E (red) v S&P 500 ex Mag 7 (green)

Source: yardeni.com

Due to the high valuations we see today in the US, Vanguard, the Fund Manager, forecast a 10-year future return for the US stocks of only an average 1.7% per year from here, because they expect these PE valuations to slowly decline, and that will be a drag on US stock performance. In contrast, they see 6.1% average future returns over the next 10 years both for Euro area stocks, and also for stocks in the world outside of the US.

Let’s focus on the AI investment trend that we continue to see, a trend that has fueled to a large extent the outperformance of the Magnificent 7 lately. Four hyperscalers out of the Magnificent 7, namely Amazon, Meta, Google, and Microsoft, are looking to invest even more, largely on AI in 2025, totaling investment capex of $325 billion. This is substantially more than the already massive $220bn that they have spent

In 2024, and they intend to spend massive amounts on AI in 2026 and 2027 as well. So if we look over this four or five-year period, we're talking a total investment potential of maybe a trillion dollars or more.

There are questions, in my view, over the eventual return on investment from this massive multi-year investment wave, clearly, I think, brought into question by the launch of the Chinese large language model DeepSeek, and also the arrival of the Chinese more broadly, including competing models also from technology giants such as Alibaba.

I think this will lead to commoditization of AI, which is eventually good for economic productivity, because the lower entry point, thanks to the massive offer of generative AI and other AI models on the market, will drive down prices for all. This in turn will accelerate the adoption of AI in the wider economy, in sectors outside of just technology.

That's the good news, which, well, again, we think boost economic productivity, and that could take in the long run US economic growth up to something like a 2% growth in productivity over the medium term, which is about as high as it ever got in previous technology booms in the early 90s with the introduction of the PC, and around the year 2000 with the acceleration of the adoption of the internet.

That could be good for very many sectors, including software, banking, professional services and healthcare, given this accelerated AI adoption of the wider economy, but I'm not so sure this will be good for the companies supplying the AI models, the aforementioned hyperscalers, even given these higher volumes, with the lower potential prices and the lower, therefore, potential profit margins.

So I would conclude that while the US may still outperform for a little bit longer, I think we're getting a bit long in the tooth in this outperformance trend both at the economic and at the stock market levels.

So I would advise those who have heavily invested in US stocks and, of course, done extremely well from this exposure over the last few years to diversify away from this heavy US stock exposure and the heavy exposure to the technology sector, as nothing lasts forever.

Bear in mind that the US stocks today comprise nearly 74% by weight of the MSCI world index, and that's a record concentration to have in one country today. In other words, even if you invest in the MSCI world index, you may think that you are investing in the global stock market, but actually nearly three quarters of that investment ends up in the US, which is not really that well diversified.

MSCI World index Country breakdown

I would suggest to consider other asset classes, but at least to think about other stock markets, such as the Euro area, the UK, Japan, and perhaps even China particularly starting with these technology companies, given that they are very cheap, given that they're still growing well, and that they are also starting to exploit the same AI trends that are being clearly exploited in the US.

Hang Seng Technology index has rallied post DeepSeek release

Have a great week

Edmund